WASHINGTON — The United Kingdom's referendum last month to leave the European Union could have serious and lasting effects on global financial stability — effects that could have an impact on the U.S. economy, the Office of Financial Research warned in a report released Monday.
In its semiannual report on financial stability trends, the independent arm of the Treasury Department said that the U.K.'s surprise vote June 23 has harmed investor confidence. Director Richard Berner said that the move has shaken an already fragile post-crisis global economic recovery, and could have a lasting impact as the details play out in the coming months and years.
"The result of the U.K. referendum surprised financial markets and was a negative shock to investor confidence," Berner said. "It introduces months or years of uncertainty about the rules governing the U.K.'s investment, financing and trade relations with Europe and the rest of the world."
That effect could be felt most acutely in the U.S., Berner said, because of the uniquely close financial relationship that the two countries share, and the close trading partnership that both have with the rest of the EU.
"Because the U.K. economy and especially the U.K. financial system are highly connected with the rest of Europe and the United States, severe adverse outcomes in the U.K. and spillovers to Europe could pose a risk to U.S. financial stability," Berner added.
Those risks may be transmitted through several means, the report said. U.S. companies have substantial direct counterparty exposure to U.K. firms, and a recession in the U.K. could affect the export-import relationship that the two countries share. Indirect effects, such as loss of confidence in transnational partnerships or secondary effects on driving down already low interest rates, could also destabilize the financial system, the report said.
Most of the risks outlined in the previous report, issued in December, also remain unresolved. Those include the elevated credit risk exposure of some U.S. nonfinancial businesses to unstable foreign markets, the ultralow interest rate environment and the "reach for yield" behavior that it encourages, and "uneven resilience" within the U.S. financial sector. The report also noted that in addition to the U.K. referendum, the U.S. faces declining corporate profits, which may stall investment and hiring.
"It remains to be seen if this slowdown is transitory," the report said.
Other risks remain either unresolved, difficult to measure or both. The report noted that liquidity and funding risks remain, even though risks associated with short-term wholesale funding have improved substantially since the 2008 crisis. Reforms to money market funds have allowed those funds to float according to the net asset value of the fund, the report said, but "run risks persist in some money market funds and short-term investment vehicles."
Market liquidity, which has been the subject of several government and industry studies in recent years, has been another hard-to-predict market behavior. Traditional metrics have proven to be unreliable in stress environments, and the report noted that the potential for stress in one market to infect others — so-called contagion risk — remains "greater than available metrics indicate."